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Investment case for you: would you buy this business?

australianinvestor

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I just responded to an interesting thread (http://thefastlanetomillions.com/showthread.php?p=28476) in which business valuation was discussed.

I thought it might be worthwhile to give you a simple case where a business is for sale, to see if you'd buy it, and what price you'd pay.

The (fake) case

A widget company based in Somewhereville, USA.

  • Income: $20,000 per month from widget sales.
  • Expenses: $8,000 per month (salaries, insurance, lease)
  • Gross profit: $12,000.
I am purposely making the financials this simple to reduce the complexity of the decision. I am also purposely not posting a balance sheet. Not for this example at least.

EDIT - This is a completely passive business. You are evaluating a going concern, which doesn't require any (mandatory) presence of yours.

The question

1. How much would you pay for this business? Providing this business performed exactly as I described above, every month for the next 25 years, how much would you pay?
I want you to write a number. Just analyse what it would be worth under these conditions.

2. How did you come up with this number?

3. What are the key things you want to know before you'd invest?


I'm looking forward to this, I like working this stuff out. Hopefully you do too!

Daniel.
 

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australianinvestor

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Should this go well, would you like me to post a more complex, maybe even real-life case regularly?

I think valuing investments is a vital skill that needs to be developed, and here is a great place to get some practice in.

Daniel.
 

biophase

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I have a few questions. You can't evaluate the business based on its monetary numbers only. How many hours per week do I have to put into this business?

Is this an online business? Is it retail? B2B? Number of employees?
 

JScott

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Agreed with Biophase that you need a lot more information about a business before you can determine its value...this is why M&A (merger and acquisition) teams spend weeks, months and sometimes years doing evaluations before making a decision on whether to buy and for how much...
 
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australianinvestor

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I have a few questions. You can't evaluate the business based on its monetary numbers only. How many hours per week do I have to put into this business?

Is this an online business? Is it retail? B2B? Number of employees?
I just edited my post to mention that it's a passive investment you are evaluating. Thanks for reminding me that I forgot this.

There's a specific way of thinking about this that I wanted people to discover, if they didn't know it already. I debated with myself for the last few moments whether I should just write it, and I will (otherwise this thread might become a bit of a mess!)...

This example is all about asking yourself "How much am I prepared to pay for this stream of cash flow?"

Bio's questions are very important, but I want to leave them for another case.

How much would you be prepared to pay for this business if it generated $12K a month for the next 25 years, guaranteed, and was a passive investment?

Daniel

(Sorry for not being a bit clearer!)
 
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JScott

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Based on above, I'd be willing to pay about $1M, as I think a 15% completely passive, non-compounded (simple) return is about the best I could do with other investments I might consider (assuming I did my math correctly :)).
 
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australianinvestor

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Couldn't find a suitable program online so... I did this by hand ;).
Assuming the $12K or $240K is invested yearly at an annual rate of 5%. Which is pretty close to the long term 30 year Tbond yield.
You will end up with $11.2145 million by the 25th year.
Which has a present value of $3.4773 million. I may be off a bit, since I've never been good with bonds.
Now that assumes interest rates will remain at 5%.
If interest rates are at 8% on average in the 25 years, FV in 25 years if $17.3054 million, with a present value of $2.7291 million.
10% on average yields $23.3632 million, PV of $2.372 million.
Now if you're Warren Buffett and think you can make 20% in stocks unleveraged after-tax(to simplify calculations.), in 25 years you'll have $113.03 million, with a present value of $1.4218 million.
I'm typing in the dark and am too tired to be able to really read into your post, but Microsoft Excel and OpenOffice Calc can do these calculations. :)
 

randallg99

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The (fake) case

A widget company based in Somewhereville, USA.
  • Income: $20,000 per month from widget sales.
  • Expenses: $8,000 per month (salaries, insurance, lease)
  • Gross profit: $12,000.
.....

The question

1. How much would you pay for this business? Providing this business performed exactly as I described above, every month for the next 25 years, how much would you pay?
I want you to write a number. Just analyse what it would be worth under these conditions.

2. How did you come up with this number?

3. What are the key things you want to know before you'd invest?


I'm looking forward to this, I like working this stuff out. Hopefully you do too!

Daniel.

entirely passive investments still carry risk and I would expect a return of 15% on my money. Otherwise foreign funds can provide zero risk at 7-8%. A mistake I see many people make in buying businesses is that they choose to buy a J-O-B and dont take in consideration the effort to focus on the big picture for the business is just as demanding as running day to day operations, but the same person will have difficulty doing both especially recent retirees shifting from corporate worlds.

but to answer your Q-
Assuming there are no carrying costs for funding, I would pay 800k to net an 18% return cash on cash investment and 144k annual income.

alternative would be to buy real estate using same parameters but the net worth is more tangible and would expand after costs.
 

kimberland

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I agree with TheGreatBear,
this isn't a business eval,
this is a bond eval.

For a business eval,
you'd start with a NPV of cashflow discounting at 10%+ for the first 10 years
(adding on current NBV and adjusting from there).
Why 10 years?
Because it is darn difficult to project any business out past a decade.
Even when I eval'ed solid blue chips, I didn't look past a decade.
 
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australianinvestor

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I've seen some excellent thinking :)

It is indeed just a bond valuation in a different form.

Kimberland's comments on the difficulties of projecting into the future are right on the money :)

Excellent discussion, I'll have to get a real case and we can add the beautiful chaos created by all the other aspects of business!

Oh, and some reputation points as well!
 

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phlgirl

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Great thread, Auzzie!! Thanks for starting it. ++++

I am new to the business evaluation process - currently devouring books on the topic - but, for now, I would go with Randall. I have been looking at it from a return standpoint and it will have to be at least 15%.

I also need there to be a clear and sustainable path for growth.

Without additional info, my answer would be 960k max.

And, yes, I would love to see 'more complex, maybe even real-life cases posted regularly'!! I certainly intend on posting (in disguise) my potential candidates and think the practice might be great learning for everyone.
 

PurEnergy

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austrailianinvestor, excellent thread. Speed +

This will be a great start to my education of business analysis I hope you keep going.

Without trying to be cute, did you just read a book on this or is there another thread where we can find your credentials to write about the subject?

Off hand I went with the 15% return and $960,000. What bothers me is the debt of $960,000 and the risk involved in getting that paid off in a timely manner. Things change on a dime these days. I would want the debt paid for in 5-7 years.

Thanks for the thread.
 

biophase

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I don't have any experience in evaluating businesses, but I feel like everyone is offering very high dollar amounts.

My initial reaction in evaluating this biz before the additional information was:
If its restaurant: $250,000
If it has no employees home biz: $360,000
At 100% passive: $1,000,000 is a 14.4% return

Problem is that we can't evaluate risk. But if you assume that it will shoot off $144,000 a year for 25 years and that is set in stone. Then you can offer alot more than $1,000,000. The question is what happens after the 25th year? Can it go another 25 years?

I'd think that most people who buy a business with hopes of increasing its sales and revenue. If you say that revenue is fixed, then it really has no upside, just alot of downside.
 
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australianinvestor

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austrailianinvestor, excellent thread. Speed +

This will be a great start to my education of business analysis I hope you keep going.

Without trying to be cute, did you just read a book on this or is there another thread where we can find your credentials to write about the subject?

Off hand I went with the 15% return and $960,000. What bothers me is the debt of $960,000 and the risk involved in getting that paid off in a timely manner. Things change on a dime these days. I would want the debt paid for in 5-7 years.

Thanks for the thread.
I have an MBA, have owned a number of companies in two countries, and have analysed more deals than I care to remember :)

If you want to learn more, the basics can be found in finance and accounting courses/text books. :)
 

aivern

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Feb 9, 2008
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Curious excercise...


$720,000.00 would be my highest bid... I would expect a minimum return
on initial investment of 20% because of the risks that are involved in
the business and some mad prvisions for inflation and Taxes...

I do not know what the situation is like on your end australian investor
South African businesses tend to sell on a payback period of 3 years
which would give a value 432,000.00 thats cool. It is generally cheaper
to buy whole small businesses here than shares I have learned.

Things get complicated if the seller starts to telll you about the growth
portential of the earnings.

Anyway this is what I would want to know...

1) Why are you selling...
2) What is the Free Cashflow from the business...
that is how much can I take out of the business without harming future cashflow
3)What is the historic growth in earnings
4)Are the earnings of good quality...
 

MJ DeMarco

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While I appreciate this exercise as it has generated a lot of brilliant (and true) comments, evaluating a business looking only at these numbers would be like buying a car because it has sparking rims and new tires.

Until you look under the hood, check the CarFax, service records, comparables in the marketplace, no value can be placed.

Now based on the information presented (removing the 25 year cash flow guarantee), I wouldn't pay more than 3 Times net earnings and here is why:

1) The product is a widget and manufactured in the US.
2) The owner is experiencing high margins.
3) Since high margins are being realized, new competitors will enter the marketplace and start eroding the margin.
4) New competitors will most likely manufacturer the product in China ... further escalating the margin deterioration.

This is why such a business can't be properly valuated -- the market, the competition, barriers to entry all are apart of the business valuation recipe -- its been omitted in this exercise hence no answer is right or wrong.
 

JScott

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I took the question to be predicated on Aussie's following comment:

This example is all about asking yourself "How much am I prepared to pay for this stream of cash flow?"....How much would you be prepared to pay for this business if it generated $12K a month for the next 25 years, guaranteed, and was a passive investment?
As TheGreatBear pointed out, this can then be reduced to evaluation as a bond or other fixed-return investment.

Of course, though, I think we all agree that this isn't a realistic description of any existing business... :)
 

randallg99

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just a few hours ago I was talking with someone who is looking to sell their biz and thought of this thread....

revenue- almost 1mil
net profit after all expenses - about 10% (100k)
some possible opportunity for growth, but with added expenses
little competition at this time

my offer was probably a little insulting at 300k but the reality is that if he does not sell the biz, then it disolves... there is no inventory and goodwill does not go very far in todays credit climate.
 

aivern

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Is it prudent to use the 25 Year bond valuation process given that the cashflows of this business are at best guesstimates in the 3rd year and further. Someone mentioned Buffet earlier and I did a bit of revision... His investments have generally had an initial ROI (return on investment of 5% the 89 coca cola purchase I think was actually about 11%. Moreover he is buying businesses with growing earnings that is why he is willing to pay 20 times the company's earnings. He figures if the earnings continue to grow like this I should be able to get back my initial investment in 5 to 7 years. With the figures supplied. That is there is no mention of growth in earnings. Focus on returning your money in at most 7 years from those cashflows.

I have not yet read on real estate investment... I generally know that the payback period for real estate from rentals is normally that high. Which brings me to the question why do banks prefer to finance assets that willl payback over such a long period of time rather than small businesses that can pay back in less time.

randallg99 is really not being rude by asking for that much (well little if you like) ... I think its in the model. see www.aldes.co.za for sellers on another planet who are selling for no more than 24 times monthly profits for sweet businesses. P.S South Africa is much more stable than Zimbabwe and these businesses are in Saouth Africa
 

jganz

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you wrote

"How much would you be prepared to pay for this business if it generated $12K a month for the next 25 years, guaranteed, and was a passive investment?"

as others have said.. there is not enough information here...

but.. if it is GUARANTEED..(not sure how.. but this is imaginary here)

id be willing to pay about 10k per month... my first thought was id pay $11999 a month since id still be making a dollar a month for doing nothing.. but

2k per month would be enough for me to deal with the paperwork involved in it...(totally passive for me is never quite totally passive)

so.. not sure if this translates but id pay 10k per month * 12 months * 25 years.. or

3 million dollars.. (since its guaranteed profit)
 

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biophase

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just a few hours ago I was talking with someone who is looking to sell their biz and thought of this thread....

revenue- almost 1mil
net profit after all expenses - about 10% (100k)
some possible opportunity for growth, but with added expenses
little competition at this time

my offer was probably a little insulting at 300k but the reality is that if he does not sell the biz, then it disolves... there is no inventory and goodwill does not go very far in todays credit climate.
$300k is not insulting at all. Why would you think that was low?
 
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australianinvestor

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I am delighted with the level of discussion in this thread, and would like to reveal a few of my motivations in posting it.

- I wanted to see the kinds of valuation methods people use
- I wanted to see how the thread goes, so if I spend time preparing a complex case, it is a good investment of my time (ie: people actually value the results)
- I wanted to see the kinds of information people need (and think they need) to make a decision (hence the artificially simple/limited info :)

I'm proud of everyone for giving it a go, and I enjoyed the discussion immensely. If you'd like me to, I'll try and find a real life business for sale, and analyse it.

I might even make a call to the owner, record it, and gather some information for us to analyse. Everyone could listen to the call, hopefully learn a thing or two, teach me a thing or two, and come out of it as a better investor. Maybe if anyone is interested in the business, we could record further calls like negotiating the price and so forth.

Sound good?

Daniel.
 
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australianinvestor

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$300k is not insulting at all. Why would you think that was low?
I agree. If this guy is going to lose if no-one buys, hammer it down as low as you can. He should be motivated to sell. Just make sure that his business baggage doesn't stick around to haunt you after the purchase. :)

Daniel.
 

JScott

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id be willing to pay about 10k per month... my first thought was id pay $11999 a month since id still be making a dollar a month for doing nothing..
But you could put that $11999 in a CD and make about $50 per month.

Why would you settle for $1/month if you could just as easily make $50 per month?

You *can* make $1/month for doing nothing. There are plenty of people out there who will pay you $1/month for a $11999 loan, guaranteed return...in fact, I will... :)
 

Jito

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Gross Profit 12,000
Taxes (35%) <4,200>
Net 7,800

$7,800 * 12 months = $93,600 a year

Using a .20 discount rate...... 93,600/.20 = 468,000 is my offering price. Assuming this will indeed continue to pay me at a current rate. But its business, so I would actually offer half $234,000 cash. Take it or leave it.
 

JScott

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Gross Profit 12,000
Taxes (35%) <4,200>
Net 7,800

$7,800 * 12 months = $93,600 a year

Using a .20 discount rate...... 93,600/.20 = 468,000 is my offering price. Assuming this will indeed continue to pay me at a current rate. But its business, so I would actually offer half $234,000 cash. Take it or leave it.
That's a 61% guaranteed (simple) return on your investment...my guess is that you'd settle for less... :)

At least most people would...
 

Jito

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Although I did value the business like a bond/annuity, I took into account a huge amount of uncertainty with a large discount rate, and even then cutting the 486,000 offering price in half.

Sure maybe I would pay a little more than $234,000, but without any future guidance its very hard to make an educated offer. An interesting exercise regardless.

Perhaps this company makes dvd players, and in two years will be obsolete w/ blu ray and hd dvd. If thats the case hopefully I didn't pay for a continual stream of income....
 

WheelsRCool

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australianinvestor, cool thread, just make sure if you record a call with the business owner for people to hear, that you get permission first!

So to start learning to value businesses, I should study finance and accounting (I am doing this right now) and then move onto business valuation books?

Also, is learning to value a business for buying it and learning to value a business to invest in it two different things?

So much to learn!!
 

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